‘Darling’ sterling faces strong headwinds

The UK pound has steadily appreciated against leading currencies during the past year, as positive economic data have provided a much-needed boost – but Scotland’s looming referendum on independence and escalating fears of a UK housing bubble suggest the rally is reaching its final stages, predict analysts.

The days of two
dollars to the pound are but a distant memory, as the pound
was decimated in the aftermath of the global financial
crisis.

In January 2009, cable (GBP/USD) fell to as low as 1.38
while GBP/
EUR almost hit parity, and cable has mostly hovered in the
mid 1.50s since, while the UK languished in recession.

However, the UK has finally emerged from recession, and
positive economic data have given the currency a fresh fillip.
The UK economy grew by 0.8% in the first quarter, according to
statistics from the Office for National Statistics.

The National Institute of Economic and Social Research said
earlier this month UK economic activity is increasing towards
pre-financial crisis levels, and upgraded its
2014 growth forecast to 2.9% from 2.5%. This has benefited
sterling at a time when leading currencies are largely
benign.

"The UK pound has generally outperformed its peers in what
is a low-volatility environment," says Paul Chappell, founder
and chief investment officer at currency management firm
C-View. "Net moves in most major currencies have been
relatively small since the beginning of the year."

Cable is now trading at 1.68 and market participants predict
it will break through 1.70 for the first time in years. GBP/EUR
has steadily risen higher to the current level of 1.22.

"[Sterling has] been the darling of FX markets; the market
is desperate for yield," says Neil Mellor, currency strategist
at BNY Mellon. The bank predicts cable will hit 1.70, before
levelling out to 1.66 at the end of the year.

Sterling peak

Indeed, analysts predict that, while sterling has room to
appreciate a little more, current valuations are starting to
look stretched.

Morgan Stanley’s FX research team forecasts
that this week’s retail sales figures (May 21)
will be below-consensus and "it could take larger upside
surprises for GBP to remain supported".

Furthermore, there are a number of potential headwinds
– Scotland’s referendum on independence
from the UK is edging closer. Scotland will vote on September
18 whether to leave the UK and exist as an independent country,
which analysts agree would be disastrous for the UK pound. The
fear of a yes vote alone could trigger a sell-off of
sterling.

"Do we really think there will be a yes vote?" asks
Chappell. "Probably not, but if the polls suggest otherwise
that will absolutely cause uncertainty.

"If Scotland were to vote yes, that would mean everything is
up for negotiation between the rest of the UK and Scotland,
which would cause some sort of a hiatus. The fear of it
happening will possibly drive the pound weaker throughout the
summer."

Meanwhile, the UK housing market is concerning analysts and
central-bank officials alike.
Mark Carney, governor of the Bank of England (BoE), warned
on Sunday the housing market has "deep, deep structural
problems" and poses the biggest threat to the UK’s
economic recovery.

Analysts will mull over this week’s breakdown
of UK GDP figures to look for signs the UK is moving towards
more investment-focused growth, as opposed to growth that is
fuelled by rising house prices. This would support sterling in
the longer term.

Analysts are recommending a number of short- and long-term
sterling trades, including selling EUR/GBP. The
European Central Bank is reportedly considering a number of
options to boost inflation, while in the UK the focus is more
on when the BoE will raise interest rates.

"Positive forward-looking indicators and expectations for
incoming investment are likely to keep UK asset markets well
supported, allowing GBP to sustain gains over the medium term,"
says Morgan Stanley’s FX research team in a note
published on Monday.

However, some analysts believe all good things have to come
to an end and are more bearish on sterling over the
longer-term. UBS’s official three-month forecast
for cable is 1.60, and it is recommending clients go short
sterling.

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